London School of Economics EOPP: Economic Organisation and Public Policy Programme LSE
EOPP: Economic Organisation and Public Policy Programme

Contract Structure, Risk Sharing and Investment Choice

Greg Fisher

Abstract:

Few microfinance-funded businesses grow beyond subsistence entrepreneurship. This paper considers one possible explanation: that the structure of existing microfinance contracts may discourage risky but high-expected return investments. To explore this possibility, the author develops a theory that unifies models of investment choice, informal insurance, and formal financial contracts. He then test the predictions of this theory using a series of experiments with clients of a large microfinance institution in India. The experiments confirm the theoretical predictions that joint liability creates two inefficiencies. First, borrowers free-ride on their partners, making risky investments without compensating partners for this risk. Second, the addition of peer-monitoring overcompensates, leading to sharp reductions in risk-taking and profitability. However, the theoretical prediction that group lending will crowd out informal insurance is not borne out by experimental evidence. While observed levels of informal insurance fall well short of the constrained Pareto frontier under both individual and joint liability, joint liability increases observed insurance transfers. Equity-like financing, in which partners share both the benefits and risks of more profitable projects, overcomes both of these inefficiencies and merits further testing in the field.

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Contract Structure, Risk Sharing and Investment Choice